What is Implicit Cost?
Implicit cost refers to the opportunity cost of the resources of the business organization also known as notional cost or implied cost where the organization calculates what the business earned if instead of using the resource in the business activity, it used the resource for some other purpose say if the business has rented such asset to another party then how much rent they would have earned will be considered as opportunity cost.
As the name implies, implicit costs do not represent real expenses. Still, they are considered as a form of the opportunity cost for the utilization of a company’s assets or resources in general. For instance, if a company sets up a production plant on its land, by implication, it did not earn any possible rent on the same property it could, if it were not to use the resources itself.
It must be borne in mind here that implicit costs do not represent any real expenses. However, the utility of this measure lies in the fact that it helps to evaluate if a particular resource could have been employed better.
Implicit and Explicit Costs
To better understand implicit costs, it would be necessary to understand explicit costsExplicit CostsExplicit cost refers to the business expenses that impact the organization's profitability and are recorded in the general ledger. Such costs are the expenses that appear in the income statement. as well, which are out-of-the-pocket expenses, incurred on business activities and operations. By contrast, it helps to take into account probable alternative use of resources and returns thereof. The total costs incurred for a company typically represent the total of both types of costs.
How to Calculate Implicit Costs?
If renting out a fixed asset could result in higher earnings as compared to what a company earns by utilizing that fixed asset for their operations, it means that the company is losing in terms of economic profitEconomic ProfitEconomic profit refers to the income acquired after deducting the opportunity and explicit costs from the business revenue (i.e., total income minus overall expenses). It is an internal analysis metric used by the organizations along with the accounting profits.. In simple words, there is no use employing its building for running its operations, if a company can’t earn more than the implicit cost of renting it out.
The problem with calculating such costs is that they are often hard to quantify, do not figure on the financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. of a company, and are generally more or less intangible. Other typical examples of implicit costs would be the time and resources invested in training an employee, depreciation of the equipmentDepreciation Of The EquipmentDepreciation on Equipment refers to the decremented value of an equipment's cost after deducting salvage value over the life of an equipment. It lowers its resale value., etc.. However, depreciation could still be technically considered as an explicit cost by some because it represents realistic capital consumption for a resource for which a real expense was made, even if earlier.
Implicit Cost Example
ABC invested a sum of $10,000 in certain businesses intending to earn probable profits to the tune of $5000 in a year. However, to make this profit, he had to forego the interest he could earn on the sum. Let us suppose that he had to forego a 12% annual interest, which would have worked out to $1200 in a year. This $1200 represents the implicit cost of investing the sum elsewhere.
Use and Relevance
For understanding the relevance of these two types of costs, it is important to know that they are widely employed to calculate different types of profit. There are several ways of defining profit, and two of them are accounting profit and economic profit.
Accounting profit is calculated by deducting explicit costs from total revenues. It represents the calculation of profit-takingThe Calculation Of Profit-takingProfit taking is when the investors sell the assets, mainly shares and securities, when the price rises. The aggressive investors wait for the desired percentage hike in the share's prices and then opt to sell the shares or securities in the market. into account real expenses incurred on running business operations.
It can only be calculated by deducting both explicit and implicit costs from total revenues, which would give a better idea of whether the resources were employed profitably enough, or they could have been employed better. Economic profit tends to be lower than accounting profitAccounting ProfitAccounting profit is the net income available after deducting all explicit costs and expenses from total revenue, and it is calculated in accordance with generally accepted accounting principles (GAAP). Operating expenses, labour, transportation, and sales expenses are common examples of these costs. most of the time.
Implicit Cost Video
This article has been a guide to Implicit Costs, its uses, and relevance. Here we also calculate Implicit Cost along with an example. You may learn more about Corporate Finance with the following articles –